Tuesday, 23 September 2008

5 Lessons for the Next Financial Mania

By Rick Newman

Why do we keep relearning the simplest rules in the world?

Buyer beware. Cut your losses. What goes up must come down. If it seems too good to be true, it probably is. No matter how complex the market meltdown of 2008 might seem, all of these simple aphorisms--clichés, really--directly apply.

Of course, in every financial free-for-all--whether it's the S&L crisis, the dot-com bust, the Enron fraud, or today's housing-related meltdown--the chicanery takes a different form. On Wall Street, they call that "innovation." But right now, innovations like credit-default swaps and mortgage-backed securities look more like old-fashioned pyramid schemes: I'll take your money, you take somebody else's, and eventually some guy neither of us knows (or the government) will get stuck holding the bag.

Here's a guarantee: Wall Street will "innovate" again. A lot of guys in expensive suits will make a lot of money for a while. You'll want in, even if you don't completely understand what's going on. The suckers will be the ones who forget what happened in 2008. Smart investors will remember the following lessons:

The fine print matters. One of the most startling developments of the whole debacle has been the vulnerability of money market funds, which most investors consider virtually as safe as a government-insured savings account. Turns out they're not. When a couple of institutional money market funds "broke the buck" and essentially fell below the value of the principal invested in them, the government rushed to set up an insurance fund to back such funds. That's because confidence in the market is rooted in the safety of such basic accounts, where many investors park cash they might need over the short term--assuming the principal is safe.

But money-market accounts generally aren't insured by anybody, as the fine print in the prospectus no doubt points out. That illustrates a problem repeated over and over in the current crisis: A failure to understand the risks of an investment. During the housing boom, everybody focused on how much money they might make--and precious few focused on what could go wrong. Wall Street investors underestimated how risky mortgage-backed securities would be if housing prices fell. A lot of home buyers failed to do the math on their interest-rate resets, assuming it would all work out. Yeah, it's tedious to scour the fine print in such an overlawyered society. But if you don't even know what the worst-case scenario is, you'll be paralyzed if it actually happens.

Don't trust CEOs. Not because they're all liars, necessarily. But because they get paid, among other things, to be energetic cheerleaders no matter how bad their team is losing. The CEOs of Bear Stearns, Lehman Brothers, and Merrill Lynch all assured investors and the public that things were getting better for their firms, when the exact opposite was happening. Shareholders who believed them, and held on to their shares, lost a lot of money as bad investments and losses piled up. Skeptics who doubted the CEOs, and sold, cut their losses--or even made money, if they shorted the stock while the companies were on the way down.

Lehman CEO Richard Fuld wasn't just deceiving shareholders; he may even have been deceiving himself: In retrospect, it appears that Fuld had an unrealistic view of his firm's value, turning down buyout offers he deemed too low while waiting for a better offer--or government bailout--that never materialized. CEOs have an obligation to shareholders, but in reality that's second to their own self-interest--or self-delusion.

Don't trust geniuses. Wall Street is home to some of the brightest minds in the world, math and computer and finance geniuses with advanced degrees from all the best universities. If only they worked for you and me.

What they really do is find ways to make money for themselves and their firms. What they don't do is make sure their schemes serve the public interest. So a new kind of double-secret derivative might look really smart when it taps a new way to boost returns for the Bank of Brilliant People. If it works, everybody else will copy it, perhaps adding their own twists. But odds are, nobody in the system has bothered to run computer models showing what will happen if everybody starts issuing double-secret derivatives--and something goes wrong.

Theoretically, that's what government regulators are supposed to do. But the government is usually way behind the fast-thinking, overconfident gamblers on Wall Street. New regulations will attempt to change that. But the geniuses always find ways to outsmart the government and its flat-footed beat cops.

Don't trust yourself. It might have seemed like a great time to buy a house early in 2006. Interest rates were low and home values had been skyrocketing. Friends and neighbors seemed to be getting rich on real-estate deals and financing Lexuses and swimming pools with home equity. There was no reason to think the party would stop anytime soon.

But if you made your move then, you bought at the peak of the market, and chances are your big investment has lost 10 or maybe 20 percent of its value in less than three years. Yet lots of people who considered their money to be smart bought homes at precisely the wrong time. Now, the soaring foreclosure rate on many of those homes is one of the biggest underlying causes of the entire financial crisis.

People who bought at the peak of the market are generally OK if they bought a house because they needed a place to live--and plan to stay there. But millions who bought to join the craze, make easy money, or live like royalty--natural human impulses--now live in a nightmare, not a dream. And there's no government regulation that will curb greedy me-tooism.

Don't count on a bailout. It might seem like the government's writing a check to everybody with an overdue bill or two. There's federal relief for people behind on their mortgages. New insurance for investment accounts. And, of course, billion-dollar loans for troubled conglomerates.

But there's heavy political pressure to make sure taxpayers get something back, and besides, anybody who qualifies for a government bailout is already in a lot of pain. Mortgage relief, for example, goes only to homeowners who are in such dire shape that a regular bank won't help them out--and you might have to give the feds some of the cash if you sell your home for a profit. The federal loan to AIG is at such a high interest rate that the company's shareholders want to pay off the debt as early as possible. And the government could always say no, just like it did to Lehman Brothers. Whatever you consider the worst-case scenario can always get just a bit worse.

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About Me

A simple girl interested in sharing financial tips and news from the United States and Singapore. Many people focus on how to get rich. But some forget that their eventual objective is to be happy. And some also forget that the best way to be free from poverty and maintain wealth after getting rich is to be free from scams.